Mozambique - Second Poverty Reduction Support Credit

38528 Mozambique-SecondPovertyReductionSupport Credit (Cr. No. 4111-MZ) Release of SecondTranche -FullCompliance TrancheReleaseDocument 1. The Board approved the two-tranche Second Poverty Reduction Support Credit (PRSC 2, Cr. No. 411I-MZ) o f SDR 83.3 million on September 13, 2005 to support the Government o f Mozambique's primary objective of reducing absolute poverty and achieving the Millennium Development Goals (MDGs) through the implementation of the Government's Action Plan for the Reduction of Absolute Poverty (PARPA). The operation was designed as an exceptional two tranche PRSC in order to further harmonize with the other donors providing general budget support. PRSC 2 was the second operation within the framework of three operations that were designed as part o f the First PRSC approved in July 2004 (Cr. No. 3950-MZ). This two-tranche credit completes the support envisaged within the framework o f the first PRSC. The focus of PRSC 2 was to continue supporting the reform agenda supported under PRSC 1 by requiring actions to improve public sector capacity and accountability, and the investment climate. These actions were drawn from the Performance Assessment Framework (PAF) agreed between the Government and the donors providing general budget support. 2. Following the Board decision, the Development Credit Agreement (DCA) for PRSC 2 was signed on September 16, 2005 by the Borrower and the International Development Association (IDA). The Credit was declared effective on October 13, 2005. The effectiveness tranche of SDR 41.65 was released on October 13,2005. I. Background 3. Mozambique has staged a dramatic recovery from the damage o f the civil war that ended in 1992. Infrastructure has been improved and is now approaching its pre-war levels, and incomes have risen considerably. The poverty headcount fell from 69% in 1996/7 to 54% in 2002/3. On average the economy grew by 8% annually between 1996 and 2005. This- accomplishment can be attributed to the Government's phased but determined approach to stabilization and structural reforms, as well as to concessional assistance (half o f Government expenditures), a remarkable agricultural "catch-up", an expansion of agricultural exports, and fast expansion intourism, construction, and certain manufacturing subsectors. Another factor was the authorities' success in attracting "mega-projects" in aluminum smelting, natural gas, and titanium mining, and a resulting tripling of exports inthree years.  4. The recent Country Economic Memorandum (CEM) entitled `Sustaining Growth and Poverty Reduction' has examined the growth-poverty linkages. The preconditions for healthy growth were met with a reasonably stable macro environment, a comprehensive privatization program, steady progress towards liberalizing key sectors (for example telecoms, air transport), and progress in freeing up internal and external trade. In addition, there were several idiosyncratic factors behindthis growth, including significant concessional assistance, on the positive side, and recurrent droughts or floods, and a still growing HIV/AIDS pandemic, on the negative side. The CEM analyses did not find any Dutch disease effect as a result of the foreign aid flows. Productivity gains due to these financial inflows were larger thanthe currency appreciation effect. 5. Growth contributed to reducing poverty in the period 1996 to 2003 by increased consumption growth. While GDP grew at 8% in the period 1992 to 2003, private consumption as measured by the national accounts grew at a more modest 2-4%, dependingon the specific time period. Growth in agricultural output, partly due to area expansion and partly due to improved productivity, reduced poverty directly in rural areas (and in some urban areas). Non-farm activities in rural areas likewise helped to reduce poverty directly, particularly in the three southern provinces where there were stronger market linkages. 6. As the economy grew, structural change occurred. Value added was faster inthe service industry compared to agriculture, and there was a migration from rural to urban areas. During this period, Government spending -backed up by donor support - focused on the PARPA priorities o f education, health, roads, water and agriculture, which helped reduce poverty, directly or indirectly. These expenditures resulted in increased enrollments andbetter health indicators. 7. The mega-projects contributed greatly to exports and value added, but have so far had a small impact on employment and fiscal revenues even though they have had a growing impact on local business via backward linkages. The main contribution of the mega-projects to poverty reduction has been the signaling effect that large corporations have confidence to invest in Mozambique. The Government is aware that mega projects should contribute more at least to fiscal revenues. The new coal mine concession at Moatize brought an initial payment o f US123 million, equivalent to 2% o f GDP. Also the large Cahora Bassa dam and power station will soon become Mozambican property and i s expected to start paying its concession fee and other taxes by 2007, exemptions that were granted as part o f the independence agreements in 1975. 8. The Government is aware that poverty reduction requires vibrant SMEs, particularly in the rural areas, and labor-intensive exports. PARPA 11, which will cover 2006-09 and i s being finalized, will rebalance the poverty reduction agenda by focusing not only on the social sectors, but also on labor-intensive growth in all regions of the country. 9. Mozambique appears to be well placed to experience a long period o f sustained per capita growth and to achieve several of the Millennium Development Goals, such as the halving of the poverty rate by 2015. Nevertheless there are many remaining 2  challenges. It has been estimated that with swifter progress in certain key reforms, the growth rate could be as highas 7 or 8% inthe longterm, and that poverty reduction could be quicker. It is important to control inflation and manage foreign exchange fluctuations. Improvement in revenue generation is critical to be able to spend on priority sectors and make many of the investments sustainable. Total domestic revenues are projected to be 13.8% of GDP in 2005, which i s above the 12.6% collected in 2004 but well below the average for Sub-Saharan Africa. 10. Mozambique's fiduciary accountability, accounting, auditing and procurement, need to be further strengthened. The Government has embarked on a sequencedprogram of reform, starting with the new financial management law in 2001 and accompanying regulations in 2002, which set the basis both for modem budgeting and accounting procedures and for procurement reform. The electronic financial management system e- SISTAFE (the Portuguese acronym for "Integrated State Financial Management System") is beingpiloted in three ministries in2005 and 2006 and expected to be rolled out in the mid-2006 in other sectoral ministries. In parallel, the regulations and institutions governing procurement have been revised in 2005 following international standards to promote competition and transparency. 11. Further reforms - legislative, regulatory, and administrative - are required to promote private sector initiative in business and removing barriers to investment by domestic and foreign firms. Rapid expansion of exports has been one of the sources o f growth during the past 10 years in Mozambique. Much needs to be done to improve the support services for exports andto promote more labor-intensive export production. 12. The PovertyReductionSupport Credits (PRSCs):The PRSCs constitute direct budget support operations designed to align the policy agenda supported by the Bank and other donors with the national priorities formulated in the PRSP. The Bank signed the Memorandum o f Understanding betweenthe Government and the donors providing direct budget support in 2004, thereby committing itself to harmonization. PRSC 2 was designed as a two tranche operation. The first tranche was for the national budget year 2005 and the second tranche for budget year 2006. This two-tranche approach was proposed as an exceptional measure in order to adhere to the Paris Declaration on Harmonization; align future PRSCs with the budget cycle; enhance predictability; and allow the amounts o f future PRSCs to be based on the findings of the annual April/May Joint Review. 13. PRSC 1 was approved as a single-tranche operation by the Board inJuly, 2004 for US$60 million equivalent and disbursed in September, 2004. The PRSC 2 prior actions and second tranche conditions were drawn from the Government's PAF matrix and approved by the Board in September, 2005. The first tranche was disbursed in October, 2005. PRSC 2 continued supporting the reform agenda supported under PRSC I,i.e., cross-cutting institutional reforms to improve public financial management including public procurement, and the beginning o f second generation reforms. A key element i s rolling out e-SISTAFE (Integrated Financial Management System) in the Ministries o f Finance and Education and Culture and all their provincial directorates. Additionally, the 3  coverage o f the budget was to be extended by including significantly more donor- financed health expenditures within the budget framework - for example over 30% of health expenditures were off-budget in 2004 with significant off-budget expenditures in other sectors as well. After the study on off-budget expenditures inthe health sector was completed inMarch 2005, ajoint government-donor task force was set up to recommend better procedures for getting all donor projects into the budget. As a result, new guidelines for the preparation o f the 2006 budget were issued and the current budget contains a significantly larger share of donor-financed projects. A new procurement code based on international standards was to be introduced, together with a new financial institutions law, a new commercial code, a decree to ease restrictions on hiring foreign labor, andnew laws to simplify red tape and strengthen anti-corruptionmeasures. 14. The process of monitoring the PAF takes into account all sectors. Improved service delivery inPARPA priority sectors (Le., agriculture, health, education, rural water supply, infrastructure, justice and related governance sectors) and governance issues are being monitored through the Joint Sector Working Groups. Progress in achieving all the indicators contained in the PAF i s assessed twice a year through the Joint Review in April and the Mid-Year Review in September. Over the past year the sector working groups have become the best mechanism for policy dialogue, donor harmonization, and reaching agreement between the Government and the donors involved in a specific sector. Furthermore, ajoint Budget Working Group meets on a quarterly basis with the Government to monitor budget execution, particularly in the priority sectors. Even though all priority sectors are being monitored by the Bank incooperation with the Joint Sector Working Groups, it was decided that no sector-specific prior actions and second tranche release conditions would be chosen for PRSC 2; rather, they would be cross- cutting ones related to public financial management andthe investment climate. 11. Recent Economic Developments Macroeconomic Progress 15. In December 2005, the IMF completed the third review under the PRGF. Preliminary data about the performance of the economy in 2005 became available in February 2006. Real GDP growth was 8.9% in 2005 with major contributions from construction, transport, telecommunication, electricity production and water supply. A drought had a significant impact inthe second semester of 2005. Agricultural production grew by only 1.5% in 2005 and emergency food had to be imported for over 800,000 people (annual agricultural growth was 11.4% on average during the 2001 - 2004 periods). The drought, the rising oil prices and the related pressure on the exchange rate was reflected in the inflation by the end of the year. The consumer price index increased by about 5.5% in December 2005 alone reaching an end-of-period inflation of 14% and an average rate of inflation of 7.3% for 2005. 16. Regarding the exchange rate, the picture i s one o f volatility and the reversal o f the appreciation o f 2004. The exchange rate became more volatile as the market and 4  monetary authorities were adjusting to the foreign exchange auction system introducedin January 2005, and as the economy had to absorb successive external (rising oil prices) and internal (drought) shocks. The appreciation o f the exchange rate that started around the middle o f 2004 due to the rise in exports and higher than expected aid inflows was reversed by May 2005. Partial stability was achieved in the middle o f the year by better liquidity management and the implementation of a 50% provisioning requirement on loans in foreign currencies to non-exporters. However, there were some weeks of instability o f the foreign exchange markets in October and November, 2005, before the exchange rate returned to the level prevailing in mid-2005. The causes of the exchange rate movements are currently being analyzed by the Fund and are being discussed with the Authorities. 17. Fiscal slippages that occurred in 2004 were corrected last year and fiscal performance corresponds to the program again. The primary domestic deficit at end June 2005 was about 1% of GDP which was considered better than had been expected, due to lower current and locally financed investment expenditures as a result o f limits imposed on the 2005 budget. The wage bill i s within the ceiling, while the share of priority expenditures was above target at the end o f June 2005. Revenue performance has improved with greater collection from corporate taxes as a result o f improved revenue administration. Reforms o f public expenditure management systems have improved, with some delays. Budget execution reports are beingproduced based on e-SISTAFE in . the Ministries of Finance, Planningand Development and Education and Culture. There are capacity limitations to rolling them out more rapidly inother ministries. 111. Progressof the Program 18. Overall progress in the Government o f Mozambique's medium-term strategy to sustain broad-based growth and reduce poverty has been good. Economic growth has been impressive during the past ten years (around 8% on average) through prudent macroeconomic policies, structural reforms and donor assistance. Poverty has been reduced due to a rapid growth in agricultural as well as nonfarm activities in rural areas. Mozambique i s expected to achieve several o f the MDGs by 2015, including halving the share o f the population living inpoverty. Second wave reforms, which are now starting, are important to consolidate macroeconomic stability, improve governance, and develop the private sector while buildingup human capital. Revenue mobilization i s key to lessen aid dependency. The draft PARPA 11, which will be discussed by Cabinet in the coming weeks, outlines a strategy to reduce poverty by rebalancing the priorities. P A W A I focused very much on the social sectors; P A W A I1 continues to emphasize the importance o f human development, but also emphasized the need for broad-based growth, particularly inthe rural areas and among small and mediumenterprises. 19. Prospects for 2006 are good with economic growth expected to be around 7.9% and inflation around 7%. Despite increases in the oil import bill, the external account deficit i s projected to decrease due to increased foreign grants. The fiscal framework for 2006 is on track. Expenditures will be tightly controlled, ensuring that the deficit stays 5  within target. Revenuegeneration is critical and total revenues are expected to increase to 14.5% o f GDP through enhanced revenue administration and the aggressive collection of tax arrears. Budgetary expenditures will reflect a constant share of current expenditures, including the wage bill at 7.5% o f GDP. Despite this resource constraint, it was possible to hire about 10,000 teachers and 2,000 health workers. Total share of spending on priority sectors will remain at around 65% which i s the PARPA target. IV. Actions Taken to Fulfillthe SecondTranche Conditions,as set out inthe Development CreditAgreement,Schedule2 20. The second tranche conditions focused on two pillars: (i) cross-cutting actions to strengthen public sector performance by enhancing efficiency and effectiveness inthe use of public resources, and (ii)enhancing the investment climate. The conditions were chosen to ensure that the second generation reforms are on track. They are evidence of the new Government's strong commitment to improve the quality of public financial management and to enhance the institutional environment for accelerated growth and poverty reduction. Conditions for second tranche release and their implementation are discussed below. 21. Condition I:Adoption of a newprocurementcode and start of its implementation as evidenced by: (a) the approval of a revised implementation action plan; (b) the carrying out of procurement audits in at least two of its ministries in accordance with the activity plan of the internal audit subsystem; (c) the preparation of a training program for civil servants and suppliers; and (d) the preparation of terms of reference for the elaboration of standard bidding documents. The Borrower has adopted a new procurement code in December 2005 and started its implementation. A revised implementation action plan was approved by the Minister of Finance and procurement audits were carried out by IGF (the Government's internal auditor subordinated to the Ministry o f Finance) in the Ministry of Education and Culture, the Ministry o f Labor, and the National Institute of Social Security. A training program for civil servants and suppliers was developed and several courses will be provided to key civil servants before June 12, 2006 when the new procurement code will enter into force. Finally, a consultant was hired to elaborate standard bidding documents, and she has already submittedthem indraft version. This condition is considered as met. 22. Condition 2: Revision of the I888 Commercial Code through the adoption of a new Commercial Code. The new Commercial Code was approved by the Cabinet as a Decreto Lei on December 27, 2005, and subsequentlysigned by the President based on the authorizationto do so by Parliament. The new Commercial Code i s available on the following official website: http://www.utrel.gov.mz/IndexAssunto .htm. 6  This condition i s considered as met. 23. Condition 3: Rollout of the e-SISTAFEto the Ministry of Education and Culture. e-SISTAFE was rolled out to the Ministry of Education and Culture in November, 2005 at the central level and all its provincial directorates. Inthis Ministry, all steps o f budget execution are now done through e-SISTAFE, and payments to the suppliers are done through the Single Treasury Account. Documentary proof of such transactions has been found satisfactory by the Bank's financial management specialists. This condition i s considered as met. 24. Condition 4: conclude the study on off-budgets in the health sector, and initiate the implementation of the study's recommendations as evidenced by the inclusion in its 2006 budgetary proposal of (a) the revenues and expenditures resulting )om the "special clinic" (clinica especial) and the "special care" (atendimento especial); and (6) a larger portion of the revenues and expenditures @om the external common funds, if compared with its 2005 budget. Ajoint task-force of donors and Government was created in2005 to propose mechanisms to bring externally financed projects as much as possible into the budget. A study o f off- budget expenditures in the health sector that was completed in March 2005 found that over a third o f all externally financed programs in the health sectors were off-budget. Most o f the health budget expenditures are from three pooled funds: one for importing drugs; one for supporting general health expenditures at the level o fthe Ministry; and one for supporting health expenditures directly at the provincial level. In 2005, about $43 million o f expenditures from these three pooled funds was included in the budget 2005, while the rest was off-budget. In 2006, the amount o f these three pooled funds that was includedinthe budgetincreased to $93 million. . This condition i s considered as met. 25. Condition 5: Legal reforms: submit bills to its Parliament revising: (a) the organic law of judicial courts including commercial sections; and (b) Revision of the Notary Code. a) The Government submitted a Bill to Parliament containing the Organic Law of Judicial Courts and this Bill provides the government with the ability to create courts o f "specialized jurisdictions," which will be interpreted as to include commercial courts. b) The Government submitted a draft bill to Parliament requestingauthorization to revise the draft Notary Code. This procedure follows the rules established under the new Constitution. The draft Notary Code i s available to on the website: www.utrel.gov.mdIndexAssunto.htm. 7  This condition is considered as met. 26. Condition 6: Combat corruption: increase, in real terms, the resources allocated in its 2006 budgetary proposal for the anti-corruption unit, ifcompared with its 2005 budget. The budget in 2005 for the Anti-Corruption Unit was about $38,000 for recurrent expenditures (without salaries) and about $58,000 for investment expenditures. In 2006, the budget for the newly created Central Office for the Fight Against Corruption, which replaced the previous Anti-Corruption Unit, is about $1,020,000 for recurrent expenditures (without salaries) and about $387,000 for investment expenditures. This is a very significant increase o f resources in2006 compared to the 2005 budget. This condition i s considered as met. 27. Considering that all six conditions for the release of the second tranche o f the Second Poverty Reduction Support Credit to Mozambique (Cr. No. 411I-MZ) have been fully met, it is recommendthat the second tranche be disbursed. 8  Annex I.Macro-Economic Indicators Mozambique: Selected Economicand Financial Indicators ~ Actual Estimated Projected Indicators 2000 2001 2002 2003 2004 2005 2006 Output, income, and prices (growth rates) Real GDP 1.9 13.1 8.2 7.9 7.5 7.7 7.9 Nominal GDP (Mt.trillion) 58.4 76.5 96.9 113.8 133.5 152.9 177.3 NominalGDP (US$billion) 3.7 3.7 4.1 4.8 5.9 6.7 6.9 Real GDP per capita -0.3 10.7 6.0 5.9 5.6 5.9 6.1 Inflation(period average) 12.7 9.0 16.8 13.4 12.6 6.3 1.5 External sector (in terms of US$) Imports (c,i.f.) at current prices 1,163 1,063 1,543 1,741 2,035 2,387 2,514 Exports(f.0.b.) at current prices 364 703 810 1,044 1,504 1,726 1,799 Terms of trade (decline - ) 8.5 -3.0 -3.4 -2.1 12.7 5.8 -4.1 Money (as % of GDP) Money and quasi-money(M2) 28.8 29.2 28.0 28.3 25.6 27.9 28.0 DomesticCredit 10.6 12.6 11.2 9.5 6.9 8.6 10.0 M2growth rate 42.4 33.2 21.5 18.7 5.9 25.0 16.0 Public finances (as YOof GDP) General governmentrevenue (excluding grants) 12.9 12.4 12.4 12.9 12.6 13.8 14.5 Tax revenue 11.8 11.0 11.0 12.0 11.7 12.4 12.8 Nontax revenue 17.1 16.9 15.8 16.6 15.5 16.8 17.7 Expenditure 26.6 32.1 30.0 26.9 24.7 27.1 27.5 Currentexpenditure 13.1 13.5 13.9 14.8 14.5 14.5 14.5 Capital expenditure 13.5 18.6 16.1 12.2 10.2 12.6 12.9 Unallocatedrevenue or expenditure 0.0 0.1 -0.2 0.4 0.0 0.0 0.0 Overall deficit before grants(-) -13.7 -19.9 -17.3 -14.4 -12.0 -13.3 -13.0 Overall deficit afier grants(-) -5.8 -6.0 -7.2 -4.5 -4.5 -5.6 -3.9 Savings and investment (as YOof GDP) Gross domestic savings 11.6 8.0 11.0 10.1 12.3 11.9 13.8 Gross domestic fixed capital formation 33.5 25.9 29.8 25.9 20.7 22.2 23.8 External currentaccount balance(before grants) -27.2 -26.1 -23.1 -19.9 -14.1 -17.0 -17.4 Aid/GDP 14.7 21.2 15.1 13.8 12.7 12.7 13.2 Other indicators Gross official reserves In millions o f US$ 745.3 727.0 824.8 947.2 '1159.2 1076.2 1068.3 In months of imports of goods and services 5.8 5.1 5.4 6.0 5.1 4.0 3.7 Exchangerate-periodavg (local currency US$) 15227.2 20703.6 23678.0 23782.3 2258I.3 2275I.8 25756.7 Net presentvalue of external debt as percent of 3 year moving average of exports 177.1 109.8 91.7 102.0 83.8 83.6 89.5 Source: Local DataBase, inturn from Mozambiqueauthorities, IMF and staff calculations.